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1、After studying this chapter, you should understand:LO1 How to determine the relevant cash flows for a proposed project. LO2 How to determine if a project is acceptable. LO3 How to set a bid price for a project. LO4 How to evaluate the equivalent annual cost of a project.LEARNING OBJECTIVES298Capital
2、 BudgetingPA RT 410MAKING CAPITAL INVESTMENT DECISIONS IS THERE GREEN IN GREEN? General Electric (GE) thinks so. Through its “Ecomagination” program, the company planned to double research and develop ment spending on green products, from $700 million in 2004 to $1.5 billion in 2010. With products s
3、uch as a hybrid railroad locomotive (described as a 200-ton, 6,000-horsepower “Prius on rails”), GEs green initiative seems to be paying off. Revenue from green products was $14 billion in 2007, with a target of $25 billion in 2010. The companys internal commitment to reduced energy consumption save
4、d it more than $100 million from 2004 to 2007, and the company was on target to reduce its water consumption by 20 percent by 2012, another consid-erable cost savings. As you no doubt recognize from your study of the pre-vious chapter, GEs decision to develop and market green technology represents a
5、 capital budgeting decision. In this chapter, we further investigate such decisions, how they are made, and how to look at them objectively. This chapter follows up on our previous one by delv-ing more deeply into capital budgeting. We have two main tasks. First, recall that in the last chapter, we
6、saw that cash flow estimates are the critical input into a net present value analysis, but we didnt say much about where these cash flows come from; so we will now examine this question in some detail. Our second goal is to learn how to critically examine NPV estimates, and, in particular, how to ev
7、aluate the sensitivity of NPV esti-mates to assumptions made about the uncertain future. So far, weve covered various parts of the capital budgeting decision. Our task in this chapter is to start bringing these pieces together. In particular, we will show you how to “spread the numbers” for a pro- p
8、osed investment or project and, based on those numbers, make an initial assessment about whether the project should be undertaken. In the discussion that follows, we focus on the process of setting up a discounted cash flow analysis. From the last chapter, we know that the projected future cash flow
9、s are the key element in such an evaluation. Accordingly, we emphasize working with financial and accounting information to come up with these figures. In evaluating a proposed investment, we pay special attention to deciding what informa- tion is relevant to the decision at hand and what informatio
10、n is not. As we will see, it is easy to overlook important pieces of the capital budgeting puzzle. We will wait until the next chapter to describe in detail how to go about evaluating the results of our discounted cash flow analysis. Also, where needed, we will assume that we know the relevant requi
11、red return, or discount rate. We continue to defer in-depth discus- sion of this subject to Part 5. Master the ability to solve problems in this chapter by using a spreadsheet. Access Excel Master on the student Web site 298ros46128_ch10.indd 2981/15/09 6:20:45 PM1/15/09 6:20:45 PMCH APTE R 1 0 Mak
12、ing Capital Investment Decisions 299Project Cash Flows: A First Look The effect of taking a project is to change the firms overall cash flows today and in the future. To evaluate a proposed investment, we must consider these changes in the firms cash flows and then decide whether they add value to t
13、he firm. The first (and most impor-tant) step, therefore, is to decide which cash flows are relevant. RELEVANT CASH FLOWS What is a relevant cash flow for a project? The general principle is simple enough: A rele-vant cash flow for a project is a change in the firms overall future cash flow that com
14、es about as a direct consequence of the decision to take that project. Because the relevant cash flows are defined in terms of changes in, or increments to, the firms existing cash flow, they are called the incremental cash flows associated with the project. The concept of incremental cash flow is c
15、entral to our analysis, so we will state a general definition and refer back to it as needed: The incremental cash flows for project evaluation consist of any and all changes in the firms future cash flows that are a direct consequence of taking the project. This definition of incremental cash flows
16、 has an obvious and important corollary: Any cash flow that exists regardless of whether or not a project is undertaken is not relevant. THE STAND-ALONE PRINCIPLE In practice, it would be cumbersome to actually calculate the future total cash flows to the firm with and without a project, especially for a large firm. Fortunately, it is not really nec- essary to do so. Once we identify the effect of under
